The
Long Iron Butterfly is an intermediate strategy that can be profitable for
stocks that are rangebound. It is, in fact, the combination of a Bull Put
Spread and a Bear Call Spread. The higher strike put shares the same strike as
the lower strike call to create the butterfly shape.

The
combination of two income strategies also makes this an income strategy. Often,
traders will leg into the Long Iron Butterfly, first trading a Bull Put Spread
just below support and then as the stock rebounds off resistance adding a Bear
Call Spread, thereby creating the Long Iron Butterfly.

Ideally
the stock will remain between the lower and higher strikes, with the maximum profit
occurring if the options expire when the stock is priced at the central strike
price. In this ideal scenario, effectively all the options expire worthless,
and you just keep the combined net credit. The combined net credit serves to
widen the area of your breakevens in other words, the Bull Put element helps
the Bear Call element, and vice versa.

Market
Opinion

Direction
neutral. You are expecting little movement in the stock price.

P/L

When
To Use

Use
this income strategy when you expect little movement in the stock price, where
you earn maximum profit when the stock finished mid strikes.

Example

XXXX
is trading at $25 on April 11, 2011.

Buy
May 2011 20 strike put for $0.30.

Sell
May 2011 25 strike put for $1.50.

Sell
May 2011 25 strike call for $2.00.

Buy
May 2011 30 strike call for $0.50.

Benefit

The
benefit is, for low cost, you can make a capital gain from a rangebound stock
with capped risk.

Risk
vs. Reward

The
risk is the difference between two strikes minus your net credit. The reward is
the net credit.

Net
Upside

Net
credit you received.

Net
Downside

The
difference between adjacent strikes minus net credit.

Break
Even Point

Break
even up: middle strike plus net credit.

Break
even down: middle strike minus net credit.

Effect
Of Volatility

Any
increased volatility would have a negative effect on this position.

Effect
Of Time Decay

Positive
effect when the trade is profitable, and negative effect when it is not
profitable. The stock price is in a profitable zone when you buy it, so from
then onwards time decay has a negative effect.

Alternatives
Before Expiration

You
can unravel this position before expiration in two-leg segments.

Close
out at any time by buying back the options sold and selling the options bought.

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